Key Points:Under the Two Strikes rule, a listed company will be required to hold a spill vote if its remuneration report receives a 25% No vote two years in a row.

The Two Strikes rule to force company board spill motions comes into force today.

Under the rule, a listed company will be required to hold a spill vote if its remuneration report receives a 25% No vote two years in a row.

This rule will apply to remuneration votes after 1 July this year (for more commencement details, see below).

The rule is part of the Corporations Amendment (Improving Accountability on Director and Executive Remuneration) Act 2011. The Act also:

introduces controls on the use of remuneration consultants;

prohibits key management personnel (KMP)[1]and their closely related parties from voting on the remunerationreport and on the spill resolution;

prohibits KMP and their closely related parties from voting undirected proxies on all remuneration related resolutions;

prohibits hedging of incentive remuneration;

requires shareholder approval for declarations of"no vacancy" at an AGM;

requires that all directed proxies be voted at general meetings; and

reduces some of the complexity of the remuneration report by confining disclosures in the report to the KMP.

Two Strikes

If a remuneration report receives a No vote at two successive AGMs, the second AGM will have to vote on a spill motion. If the spill motion receives a simple majority, the company will, within 90 days, have to hold a general meeting to vote on whether to keep the existing directors. A managing director will not be subject to the spill motion[2].

Shareholders will be able to put forward their own nominees for consideration at that spill meeting.

Practical points

What happens if the spill meeting doesn't appoint enough directors to ensure that the company keeps its required minimum number of directors (3)?

The legislation says that the statutory vacancies are filled by those directors who received the highest number of votes even if they didn't receive enough votes to be formally elected.

If a company's remuneration report receives a 25% No vote year after year, does this mean that it has to hold a spill vote every year?

No – there is no requirement to hold a spill vote if one was held at the previous year's AGM

How can we plan for the AGM if we don't know whether or not there's going to be a second 25% No vote?

Unfortunately, all of the preparations for the AGM will have to proceed on the basis that there may be a 25% No vote. This means that the notice of meeting, proxy forms, etc will have to make provision for voting on a spill motion.

If a director is re-elected at the spill meeting, does he have a full term of office starting from the date of the meeting?

No. The Act says that his term of office continues as if the spill vote had never happened.

Remuneration consultants

The legislation will introduce controls on both the hiring and the work of remuneration consultants:

the board or remuneration committee must approve the hiring of a remuneration consultant;

the remuneration consultant must report to the non-executive directors (unless the board consists only of executive directors) and/or the remuneration committee (unless the company does not have a remuneration committee);

the remuneration consultant will have to provide a declaration that its recommendations have not been unduly influenced by the KMP to whom it relates; and

the remuneration report will have to provide information about the remuneration consultant and their engagement and the board will have to state whether it is satisfied that the remuneration recommendation was made free from undue influence by the KMP to whom the recommendation relates.

Practical point

Since the remuneration consultant can't report to executive directors, will they ever find out what has been recommended?

Yes, although the consultant is required to hand its report to the non-executive directors, there is no prohibition on non-executive directors handing the report on to the executives.

Voting on remuneration matters

KMP (and closely related parties) will face new restrictions on voting on matters related to remuneration:

they will not be able to vote undirected proxies on any motion related to KMP remuneration (eg. votes on the remuneration report, the Two Strikes spill vote at the AGM, directors' remuneration or related party benefits); and

they will not be able to vote on the remuneration report.

However, the chair of a general meeting will be allowed to vote an undirected proxy on a remuneration-related motion if the shareholder "expressly authorises the chair to exercise the proxy". The Explanatory Memorandum to the new legislation suggests that this authorisation could be obtained by completing a proxy form containing the statements required by the ASX Listing Rules when a voting exclusion statement is required.

KMP of listed companies will not be allowed to hedge unvested incentives.

Typically, this would prevent directors and executives from entering derivative arrangements that provide some insurance against a fall in the value of shares and options which they are to receive down the track.

The purpose of the change is to prevent directors and executives from decoupling their financial fortunes from those of the company's shares.

Practical points

What precisely does "hedging" mean?

The Act prohibits KMPs from entering into arrangements that "would have the effect of limiting the exposure of the [KMP] to risk relating to an element of the [KMP's] remuneration that … has not vested in the [KMP]".

Under new Regulations, the following would be a hedge:

a put option on incentive remuneration;

a short position on shares that forms part of incentive remuneration;[3] and

an income protection insurance contract in which the insurable risk event affects the financial value of remuneration or equity or an equity-related instrument for the KMP.

The following would not be a hedge:

an income protection insurance contract in which the insurable risk event is the death, incapacity or illness of any of the KMP; and

a foreign currency risk arrangement.

The end of the "No Vacancy" sign

At present, many public company boards can limit the size of the board to a number smaller than the maximum allowed by the company's constitution.

The new legislation will require shareholder approval to do this. That approval will have to be renewed at each AGM. Shareholders must be notified of the "no vacancy" resolution and provided with an explanatory statement as part of the notice convening the meeting.

Following passage of a "no vacancy" resolution, boards may fill board positions through the year even in excess of the number set by the board, but such appointments must be confirmed by shareholders at the following AGM, or the appointment lapses at the conclusion of that AGM.

The stated purpose of this change is to prevent boards limiting the number of vacant positions to the number of candidates favourable to the existing management.

Practical points

Does the "No Vacancy" rule apply to all companies?

No, only companies which have a provision in their constitution allowing directors to set a lower number of directors than the maximum number specified in the constitution.

How does the company plan for the possibility that the shareholders might not approve a limit on the size of the board?

As with the Two Strikes vote, the company has to plan for both eventualities – either the shareholders accept the directors' recommendation to limit the board number or they reject it. This means that, if there are candidates who are not recommended by the board, the notice of meeting will have to indicate that. Proxy forms will also have to cover the possibility that there will be a vote for more candidates that the board recommends.

The board could also plan for this eventuality by ensuring that it has enough additional candidates to fill any vacancies.

What about board limits set before 1 July 2011?

The new legislation applies to the setting of board limits on and after 1 July 2011. Boards that have set a limit before 1 July 2011 can maintain this limit until their next AGM, when they will need to obtain shareholder approval for any board limit they propose to adopt going forward. Between 1 July 2011 and their next AGM, boards cannot resolve to increase or decrease this board limit, although they could resolve to remove it.

How do boards vary the shareholder approved limit during the year without needing any further approval?

For some companies, there may be an anomaly between the intended operation of this new legislation and the provisions of a constitution where a company seeks to appoint a casual vacancy. This will need to be resolved either by an amendment to the constitution or by drafting the resolution to approve a board limit so that it takes into account the ability to appoint further casual vacancies under the new legislation in excess of any limit.

Is there any way to minimise the adverse effects of this change?

The most obvious one is for the board to abandon any attempt to limit the number of vacancies and simply put forward a slate of candidates that would fill all vacancies. However, in practical terms, this could affect director remuneration, attract unfavourable publicity and create more ongoing administrative work for management (assuming, of course, that suitable candidates could be found).

A longer term and more effective solution would be to amend the company’s constitution to reduce the maximum size of the board down to a level that meets the company’s needs. If necessary, this could be changed in later years (although would require shareholder approval to do so).

To reduce the nuisance factor of last minute candidates, consideration should also be given to amending the constitution to set a reasonable notice period for persons wishing to nominate for the board.

What happens if a board does not seek to impose a board limit?

Boards may be reluctant to undergo the process of seeking shareholder approval to set a board limit at each AGM given that, among other things, it has the potential to be a challenging communications task. Boards may instead elect to have the maximum number of directors determined by the maximum specified under the company's constitution. This will mean that if there is a contested election at an annual general meeting, and assuming that the number of directors is less than the maximum specified in the constitution, the board will not be able to say that there are less vacancies than there are number of candidates. However, a candidate for election will still need to secure the required number of votes and if necessary do so against incumbent directors.

Directed proxies

At present, proxyholders other than the chairman do not have to vote directed proxies that they hold. This means that they can cherry-pick how they use proxies: they can, for example, vote only those proxies which support their own position.

Under the new legislation, all directed proxies will have to be voted at a meeting:

if the proxyholder votes, he will have to vote all directed proxies he holds; and

if the proxyholder doesn't vote, the proxies will have to be voted by the chairman.

The requirement that unvoted proxies fall through to the chairman may be problematic when it comes to running a meeting. Until a poll has been tallied, no-one will know whether all directed proxies were voted. This means that voting may become a two-step affair, with the votes being collected and checked against the proxy information before the chairman votes any undirected proxies.

It is questionable whether the procedural burden that this imposes is really justified by the alleged problem. There is little evidence that "cherry-picking" of directed proxies is a real-life problem.

Remuneration report

The Act makes some changes to the remuneration report.

At present the remuneration report must cover the company's KMP, plus the five highest paid executives. In the case of a consolidated group, the report must also cover the KMP of the group, plus the five highest paid group executives.

Under the Act, the report will only have to cover the KMP and, in the case of a consolidated entity, only the KMP of the consolidated entity.

Unfortunately, this simplifying reform is accompanied by one which is less helpful. If a remuneration report receives a 25% No vote and "comments were made on the remuneration report" at the AGM, the next year's remuneration report must contain:

"an explanation of the board's proposed action in response or, if the board does not propose any action, the board's reasons for inaction".

The Act contains no explanation of how this is intended to work in practice. Boards will need to adopt a commonsense approach, bearing in mind that the purpose of remuneration reports is to inform shareholders in a meaningful way.

As noted above, the Two Strikes Rule will apply to votes on remuneration report on and after 1 July 2011. When determining whether a company has recorded two consecutive No votes, only AGMs after that date will be taken into account.

Other commencement dates are:

the No Vacancy changes apply to the setting of board limits on and after 1 July 2011;

the ban on hedging applies to hedging arrangements entered into on or after 1 July 2011;

the rules governing remuneration consultants apply to contracts with consultants; consultants' recommendations made on or after 1 July 2011;

proxy holders who hold directed proxies and vote after 1 August 2011 must vote all proxies, regardless of when the proxies were appointed;

if a proxy holder does not vote a directed proxy, it will only fall through to the chair if the proxy was appointed after 1 August 2011;

the prohibition on KMP voting on the remuneration matters only applies to votes on or after 1 August 2011; and

the requirement to address comments about the remuneration report applies to remuneration reports for financial years starting on or after 1 July 2011.

[1] "Key management personnel" is defined in AASB 124 as "those persons having authority and responsibility for planning, directing and controlling the activities of the entity, directly or indirectly, including any director (whether executive or otherwise) of that entity."

[2] The carve out only applies to the managing director, and does not extend to other executive directors.

[3] A short position is "a position in relation to shares in a listed entity where the quantity of the shares that a person has is less than the quantity of the shares that the person has an obligation to deliver". The Regulations then define what constitutes "having" shares.

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